Europe's Long Road Ahead

European debt scares could continue for several years as governments make their way through a sequence of adjustments. The best outcome is that, as they arise, periodic scares pass quickly and that the feared catastrophe is artfully dodged.

Greece might have been the most obvious case of an unsustainably bloated public sector depending on foreign borrowings to survive but Spain, Portugal, Ireland and Italy all have variants of the same disease.

In Greece and Italy, general government net debt is hovering around 100% of GDP, according to the International Monetary Fund (IMF). Ireland and Spain are less strained with ratios in the mid fifties but the Irish ratio has jumped from 12% in 2007 and the Spanish ratio has climbed from 26%. Without remedial measures, both are expected to track higher in the coming five years.

The deterioration in Portugal has been less dramatic but that country's slow growth could see it join the 100% club by 2015, according to the IMF, without explicit offsetting action.

Even the seemingly invincible German economy will be under pressure as it is forced to carry the weight of the others' reshuffled fiscal woes.

There are similarities between the European national situation and the way the U.S. government had to deal with its banking crisis in 2008. In the USA, all the banks had to be given access to a safety net to stabilize the financial system.

After the demise of Lehman Brothers, especially, investors and depositors were unprepared to accept that any bank was going to be secure enough without government backing. Even the most secure of them needed to avail themselves of the safety net simply to demonstrate that they were fit to survive.

In Europe, markets are pressuring governments to similarly accept externally imposed safety nets. In the past week, Ireland has been forced to accept a so-called bailout package despite the government protesting that it did not need one, raising the prospect of European central bankers being forced, one by one, to put together a package for each national government in turn.

Spain and Portugal will be placed at a competitive disadvantage in raising capital if they also do not have support packages endorsed by the European central bank and the IMF.

Right now, governments are protecting bondholders from a capital loss. However, the fight to maintain their position might be tilting at windmills as the burden of debt faced by shrinking economies grows heavier.

Icelandic president, Olafur Grimsson, had some thoughts on the way forward for the rest of Europe in the past week. According to the president, the market works most effectively when no one, or as few as possible, are quarantined from its effects.

Iceland did not try to bail out its failing banks. The president also highlighted the importance of currency adjustment as one of the mechanisms by which competitiveness can be restored and industrial growth given a boost. The recovery in Iceland began earlier and has been stronger than first anticipated.

If Iceland's experience is valid, European authorities should be planning a nasty surprise for bondholders to make sure that the inevitable burden of adjustment does not fall entirely on people who had never invested directly in the failing banks.

Historically, debt burdens have been eased through a combination of:

strong economic growth creating additional real income with which to make repayments;

high inflation to erode the real value of the debt and reduce the proportion of income that needs to be committed to its repayment; or,

some form of restructuring which forces bondholders to accept reduced payments or, at the very least, a change in the schedule of repayments.

The first is unlikely; the second will be opposed vehemently by the major European governments and central banks; leaving the third as the only feasible option. Whether or not this is called a "default" or is a more palatable "restructuring", bondholders will have to take less over a longer time frame to help spread the burden.

This leaves us with a four phase adjustment process:

stabilizing the risk by shoring up national banking systems and government finances through emergency funding mechanisms supported by international organizations and governments;

a restructuring of the debt with bondholders being forced to take a larger share of the adjustment burden than they have so far been inclined to take;

a readjustment in relative prices so that economic activity can be attracted to those regions whose debt burden is greatest;

a restoration of growth based around newly competitive industries.

Such a process implies a lengthy period during which time markets will be prone to continuing anxieties over Europe. Years rather than months or weeks may be required before any inference of a meaningful or sustainable solution can be convincingly drawn by investment markets.

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